Sunday, April 4, 2010

Innovation and Value Creation

Let's say that a person A is living in an apartment she finds sufficient at the rate she is paying, and that there are other identical apartments available for the same price. Now what would she do if her lease was up, and the rent at her current apartment was going to increase? The answer to this question depends largely on one very important factor: the transaction costs of moving. These could be the costs of van rentals, moving supply purchases, and the opportunity costs of person A's spending time searching for other housing. (To make things simple let's ignore the time value of money.) Assuming she expects to face $1000 in total costs to find and move into sufficient replacement, what would happen if her rent were to increase by $50 per month? This would amount to a $600 increase for the duration of the next yearlong lease. Clearly she would rather face the cost of higher rent ($600) than bear the costs of moving ($1000). But if the proposed rent increase were $100, for a total of $1200 she would rather face the costs of moving than the higher rent.
The transaction costs of uprooting yourself to obtain new housing are particularly high, relative to other goods. This is not the same as making a choice among buying from different vendors of apples, or electronics.
But in the situation like the one Person A faces, with high transaction costs, there is the opportunity for an innovator to create value for Person A, and profit from it. Lets assume that someone else, Person B, were able to invent an amazing new moving van that could reduce Person A's transaction costs of moving to $500. Then even with the smaller, $50 rent increase, it would be worthwhile for Person A to move. Person B could then charge person A a certain price, (less than the $100 difference between the new transaction costs and the rent increase,) and both Person A and B would benefit.
The facilitation of transactions that would otherwise not happen is one important way that innovators can create value for society. For example websites make it easier to shop around for housing, which reduces the opportunity costs for housing seekers. (The same goes for Star Trek collectibles.)
Increasing benefits and reducing costs is the essence of innovation. And in the end, innovation is the only reliable way for individuals to get abnormally rich. They must find ways to abnormally reduce the costs or increase the benefits for others, and demand a price for it. Finding ways to allow mutually beneficial trades to happen, that would not otherwise happen due to large transaction costs, is one way to achieve this goal and make a buck.